While discovering and investing in the right types of properties are two crucial steps to ensuring that your asset is capable of producing a lucrative income and appreciating in value -over time – these are not the only steps real estate investors may make in order to maximize their long-term profits.
In addition to this, you must place an emphasis on making improvements to the properties and appropriately maintaining and managing them. Did you know, though, that there are also several tax strategies that may be utilized to your advantage? Continue reading to learn more.
Tax Benefits for Real Estate Investors
If you are an investor in real estate, you already know and understand that there are several deductible expenses that may be claimed in order to experience tax benefits. What you may not realize is, there are multiple other tax strategies that may be used to increase your profits and decrease your overall tax liability.
In this guide, we are going to outline these strategies; however, we specialize in real estate, not accounting. Therefore, you should always ensure that you consult with an accountant to ensure that you are following all tax-related guidelines, laws, and procedures associated with these tax benefits. In doing so, you will find that you appreciate the upcoming tax season more than you ever did in the past.
Place a Focus on Switching to Passive or Investment Income
Many real estate investors file taxes under the “self-employed” bracket. Unfortunately, this has very high rates, in terms of taxes. While self-employment does allow you to claim your earnings as “earned income”, you should ensure that you understand the various income types. These also include “passive income” as well as “investment income”. Outlined below are the key differences between the three main types of in come -when it comes to tax purposes:
- Earned Income -With this type of income, you earn money from a job, a type of business that will provide you with a W-2, and/or you claim self-employment.
- Passive Income -With this income type, you earn money through investments that result in cash-flow, such as rental properties, and other sources. This has a lower tax rate, but you must utilize strategies such as pass-through entities.
- Investment Income -This is the amount that you gain from selling something for more than you paid – such as a property. This income is taxed in capital gains. The tax rate depends on if those gains are identified as “short-term” or “long-term”.
Make it a Goal to Only Have Long-Term Capital Gains
Now that you are ready to start taking advantage of the new type of income you will be broadcasting yourself each year with the IRS, it is time to make a goal of only having long-term capital gains. Now, what does this mean? It means that you only sell properties that you have invested in after owning them for longer than a year. If you sell before that, you will have a higher tax liability. If you sell after a year, you could have tax rates up to 20% lower than you would be charged if you classified your income as “earned”.
Learn All About the 1031 Exchange
Now, even on long-term capital gains, you will likely discover that the taxes are still a bit high after selling. Good news is, there is a way that you may defer those taxes in an indefinite manner. N
ot too many real estate investors actually know about this, but you are about to discover this little-known secret for yourself. You should start by learning all that you are able to about the 1031 Exchange.
In short, you engage in the process of “trading” one of your properties for another. Keep in mind that the word is within quotes. In trading, you defer the gains of the sale. Now, let us explain how this all works. How can you trade something you no longer own?
According to this provision, when you make a sale of one of the properties that you own, there is a 180-day window where you may use the profits of that sale to invest into a new property. You can purchase any type of property that you like. The only stipulation is that the price you pay should be equivalent to the profits you obtained from the first sale. By engaging in this technique, you are deferring the tax liability and only paying taxes with the sale. As a result, a large amount of equity builds. You may continue to do this – over and over. When you reach the final sale, you will find that you have accumulated a massive amount of equity. When electing to use this Exchange, always be sure to consult with an attorney that specializes in real estate.
Take Advantage of All Business-Related Deductions
Once you become a real estate investor, you will find that there are many business-related deductions that you may take advantage of that will help reduce your tax liability. These include -but, are not at all limited to – the following:
- If you make any repairs or any type of improvement to your investment properties, you may deduct all associated expenses.
- Many real estate investors pay a property management company to manage and/or maintain their investment properties. The fees charged by these types of companies may be written off.
- Any type of expense associated with advertising or marketing your properties -such as fliers, websites, and articles -may be deducted when you are a real estate investor.
- If you have to pay any special fees to professionals -such as maintenance companies, electricians, or even accountants -that you use in the course of your real estate business, you may deduct the costs associated with their services.
- The amount of interest that you pay on the mortgage of any investment property is deductible.
- The taxes you pay on the property, as well as the premiums associated with the insurance company of said property may be deducted when you file taxes.
- You may also write off any type of travel costs you incur as a result of your real estate investing business.
You should never underestimate the benefits associated with working directly with an accountant or a tax professional. These individuals will be able to conduct a thorough review of your company and will outline all of the deductions that are available to you. Remember, save every single receipt -be it paper or electronic. Also, document absolutely everything. If you file deductions, the IRS may – eventually -inquire about the deductions and by documenting everything and keeping track of all receipts, you will be able to quickly and easily provide any information that the Revenue Service may request.
Avoid Being Classified as a “Dealer”
If you are a real estate investor that buys and sells a lot of properties, you should be very careful. The IRS could dub you a “dealer” instead of an “investor”. If this happens, you will end up owing double the amount in FICA taxes -which is a hefty expense to carry. If you are dubbed a “dealer” the IRS will hit you with – at least -15.3% in taxes.
This will be on top of what you will owe when it comes to federal taxes, state taxes, and local taxes.
You must form a strategy that shows that – for every property you purchase and sell -it is for the purpose and intent of further investing. An ideal measure is to have your profits put towards other investment projects. You should also avoid conducting business as an LLC with one member.
You could create a S-corp or an LLC partnership, which will help change how the IRS taxes you.
If you are a real estate investor that enjoys a little change every now and then, you should consider moving into the properties that you purchase. There is a little catch to this, if you do it, you should live on the property at least 2 years. You could make improvements and various upgrades while living there. What do you get in return?
Well, if you are single, the first of the $250,000 of capital gains when you sell it is tax-free! If you are married, you get the first $500,000 in capital gains free.
If you want to earn money and not have to suffer the implications of being taxed, this is a nifty little trick that will have you maximizing your profits!
Offer Seller Financing
If you are not interested in engaging in the 1031 Exchange previously mentioned, but want to sell your property without all of the tax implications, you could do a type of installment sale where you offer seller financing. This allows you to spread out the amount of profit that you make.
You will only pay taxes and the principal that the individual buying from you pays on the first year. You may charge interest on the amount that the buyer pays you.
Now, be very selective in who you sell to because if they default and you have to engage in a foreclosure, this could prove to be very expensive.
Once your buyer has invested a set amount that you agree on, you may then transfer the property to the individual and complete a note on the mortgage, with a lien. This protects your profits and results in paying far less taxes than a straight-out sale.
Benefit from Depreciation
Did you know that as a real estate investor, you may deduct 1/27.5 of the value of your investment property each year for up to 27.5 years of ownership? This is the depreciation value. If you make capital improvements to the same property, you may also depreciate the amount of those improvements.
The only downside is, if you actually sell the property, you will have to pay back all of the profits that you did not pay taxes on in the previous years.
This is referred to as the “depreciation recapture”. If you hang on to the property, though, and NEVER sell it, guess what? You never owe on those taxes!
Maintain Ownership – Even Through Death
Well, now death is not a topic we really want to talk about, but we have to consider what will happen to the real estate that we purchased prior to our passing and our heirs. The good news is, if you die and you still own your investment properties, those that you leave the properties to will not have to pay any type of capital gains. This is because once you pass away, the acquisition costs of your properties actually just disappear. It is true that estate taxes may be owed, but unless you are massively rich (we are talking millions), the first $11 million or so of your estate is actually tax-free.
The next tax strategy that you should take advantage of as a real estate investor is to manage your properties appropriately. Property management companies will charge a small fee for their services, but it is well worth it.
These professionals are capable of tracking your expenses, your profits, keeping you up-to-date on all deductions, screening buyers and/or tenants, managing the accounting aspect of your business, and more. Best of all, you may write off these fees as an investor in properties.
We Can Help
We here at Pioneer Property Management are capable of assisting you in maximizing your profits as a real estate investor through various tax strategies. We offer expert services in all aspect of real estate management and we are backed by a solid reputation.
We offer many guarantees -such as that for maintenance, zero evictions, pet damage protection, tenant retention, results first, and customer service. We believe in proactively serving our clients, not reactively. We have assisted thousands of clients -just like you -in maintaining their investment properties and we look forward to working with you! For more information, contact us today at: 720-839-7482